'Water' in the U.S. Ethanol Tax Credit and Mandate: Implications for Rectangular Deadweight Costs and the Corn-Oil Price Relationship

Abstract

The relationship between ethanol, corn and oil prices are analyzed under two alternative situations, depending on whether or not consumers purchase ethanol on the basis of its contribution to mileage. In all cases, market prices of ethanol can be above or below the consumer price paid for ethanol. With a tax credit, we determine several key parameters affecting the price relationships between corn, ethanol and gasoline, including the relative value of the fuel tax and tax credit, and the value of corn returned to the market in the form of by-products. The outcome is further complicated if the mandates are binding or if price contingent corn production subsidies like deficiency payments are available. Empirical analysis of historical U.S. price relationships assesses the validity of the alternative models and the extent to which each policy impacted the market. The implicit subsidy of the tax credit and mandates is often higher than the observed corn price itself. We discuss several reasons for this including how corn production subsidies cause the corn price to fall below that which would occur if there was no ethanol policy. Therefore, without corn production subsidies in the past, no ethanol production would have occurred, even with a tax credit or a mandate. Furthermore, corn producers do not benefit at all from ethanol policies when the deficiency payment program is operational and very little from the tax credit when the mandate is binding. We extend de Gorter and Just's concept of water in the tax credit to include the premium due to a binding mandate. The resulting rectangular deadweight costs are estimated for the past 25 years and are found to dwarf standard triangular deadweight cost measures of traditional farm subsidies. Those who emphasize the benefits of ethanol policy in reducing tax costs of farm programs ignore new deadweight costs created by ethanol policy including an increase in the deadweight costs of the farm subsidy program. Furthermore, farm subsidies increase both the tax costs of the tax credit and the deadweight costs due to ethanol policy. Our theoretical framework provides a foundation for future research on biofuel policies while the empirical analysis gives a perspective on the relative importance of several key parameters determining the effects of past U.S. ethanol policy.